It has been quite some time since we’ve published a Coffee with Andrew. For my fellow coffee lovers, rest assured that this absence is not due to me no longer wanting (needing) a great cup of coffee, but rather a wonderful change in my life that required me to step back on Saturday mornings from our routine discussions. As some of you know, and maybe most of you that do not, my wife and I welcomed our first child in June of last year. He has been nothing short of a blessing as he has filled our hearts with a love we did not know existed. So, the time I have spent with you on Saturday was briefly re-purposed to give my wife a much-needed break from her hard work and amazing mothering during the week while I am at the office trying to navigate these financial markets. But now with Finley embarking on almost his 1-year birthday, it is time to re-engage our Coffee with Andrew as a lot has changed over the past few months. With that being said, I welcome back our long-time fellow Coffee with Andrew drinkers and welcome our new CwA friends! While we typically have published the CwA on Saturdays, I wanted to discuss the financial market price action we’ve seen so far this year. We will continue publishing the CwA on Saturdays going forward.
It has been quite a challenging year as you clearly know. For context, the bond markets have experienced one of the worst drawdowns in recent history as asset prices have re-rated due to a dramatic increase in interest rates, with equity markets not immune as they have endured the worst start to year sinceranging the early 1900’s. Many narratives have been published in the financial media that aim to explain the dramatic moves investors have experienced. We’ve seen topics range from inflation, Ukraine/Russian conflict, supply chain disruptions, Chinese COVID lockdowns, and Central Bank monetary policy just to name a few. The aforementioned narratives are merely byproducts and reaction functions of the slowing economic momentum we presaged Q4 in 2021. For those of you that did not attend, I highly encourage you to watch our Live Market Update we hosted at the end of March highlighting how the financial markets would be under substantial stress due to the lagged impact of rising rates, inflation, and robust economic momentum. You will find the recording on our newly designed website here: https://www.delosca.com/dca
While it is never fun to write bear market commentary, it is, unfortunately, a byproduct of investing in financial markets. Investors sign an invisible agreement that subjects their invested capital to good returns BUT also not-so-good returns given their cyclical nature of price performance. Unfortunately, we are in a period of not-so-good returns. At Delos Capital Advisors, it is our job to prudently manage the portfolios by positioning our client capital to the prevailing economic conditions, which we began doing last year. Our reduction of technology and retail exposure (which generated capital gains) has helped client accounts reduce the magnitude of their drawdowns (unrealized and realized losses) this year by capturing only 35% of the downside compared to the S&P 500. Recall that the less downside capture an investor portfolio endures, the quicker its corpus recovers. For example- a 50% loss requires a 100% gain to just breakeven on a nominal basis. Our process is heavily rooted in understanding the prevailing economic conditions by mapping the rates of change in the cost of money and cost of goods. Simply saying, the change in interest rates and inflation affects economic momentum. We further this econometric analysis by looking INSIDE the financial markets at asset classes, sectors, industries, and factor price action to gain clarity on how the financial markets are responding to the leading economic conditions. One of the most important clues was the correlation breakdown between higher rates and the relative performance of Regional Banking to the S&P 500. Many “professional” investors have always taunted that the higher the rates, the better the performance of financials (regional banking). While this can be true, it also can be false as higher rates become unhealthy for economic conditions. Higher rates today are not signaling economic growth but an inflation problem.
In response, we have significantly reduced our technology exposure and cyclical investments in favor of defensive, low volatility factors, investments in an effort to sidestep as much of this volatility as possible. Furthermore, we maintain a sizable allocation 1–3-month treasury bills which represents one of the lowest risk asset-class choices during this market environment. While many investors I have spoken with “bought the dip” mid-May, and even a few clients questioning me to do so, we find it prudent to sit on the edges of this volatility event with ample Risk Control asset allocation to take advantage of WHEN the “buy the dip” opportunity truly presents itself. While we are closer to that point than we were in mid-May, if today’s price action is any indication, we still have more wood to chop.
While this market volatility can be extremely uncomfortable, rest assured we are at the helm of this ship steering our course on the outer edge of this hurricane. The conditions for calmer seas ahead will center around less uncertainty on monetary policy and a further reduction in S&P 500 earning estimates for 2022. As of now, the interest rate volatility is spurred by the uncertainty of how fast and how high the Fed will tighten. Their failure to recognize the inflationary backdrop in 2021 has now put them in a sticky position to either crush inflation (which is crushing household spending and savings) or stop the bleeding of financial assets (higher rates lead to lower valuations on assets). Lastly, earnings expectations are still too lofty given the inventory glut we are beginning to see.
The silver lining is that very good companies have been derated 70-80% which could represent that the price drawdowns could be nearing a bottom. Our ample risk control allocations allow us the dry powder to take advantage of this scenario, BUT we believe it is prudent to follow our process and wait for monetary policy clarity and earnings reduction before we open the sails. As this cycle reboots, remember that the best performance comes from the depths of economic conditions just as it did following the COVID liquidity crisis in March 2020.
Sincerely, Andrew H. Smith Chief Investment Strategist
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